Lehman Japan Scandal – Repo 105 geometry (レポ105)

On the left side are the assets of a balance sheet—any balance sheet. You can put any number value on it, say 100. These are things that a company owns.

On the right side are the people or organizations that have some kind of interest or claim on that golden-colored block of assets. These are the people the company owes.

Most of that right hand side, in my example, is taken up by people’s money who lent to the company. They are the creditors. Everyone from banks to vendors to employees who didn’t get their paycheck yet. (Ignore the Repo 105 playing pieces to the far right for now.)

Notice there is a little sliver of a green block at the bottom. In this example, that represents the value of whatever the owners of the company put in to the firm. I want to expand the definition a little bit here to say that it’s anything that the government would consider to be the owner’s capital for a firm.

Right now, no one really knows for sure, but the guess is that, in the months before what is called in Japan the Lehman Shock, Lehman Brothers overall was operating with about 3% of this kind of capital. We would say 33-to-1 leverage.

Now look at this a bit: if you own a house with a mortgage, the value of the house is your asset. The mortgage the bank holds against it (as a lien in a state where it would be one), is that large liability to the right
And your “homeowner’s equity” would be that little sliver of green. In a bad housing market and one where you had to sell, that would keep you from enjoying a good night’s sleep, wouldn’t it?

Likewise, if you are a major international brokerage. In my example above, we’re assuming that the assets are all good. Or, at least, any bad portion of that asset has been “haircut” or marked-down in value so that it appears at a more realistic value on the balance sheet. (And ones whose value has gone up along the way are similarly marked up.)

Still, it doesn’t leave you much room for bad business turns, does it?

Most of the lingering problems in the recovering financial world involve this geometry and what length the rectangles are. A year ago this month (March 2009), any number of commentators believed that most major financial companies’ little green slivers had gone “poof” and at best were really just the TARP money that the government had contributed. (And this was even at regular commercial banks where the green piece was more like 8% or 10% of the whole right side, and the assets had been carefully priced.)

With this business, one firm’s assets are somebody else’s liabilities, you know. (The mortgage the bank holds as an asset is the same one you as the homeowner are paying on as a liability.) So if the rectangles start to resemble a game of Tetrix, it’s game over.

Repo 105 in the Geometry

Back to Repo 105. If you are a Lehman Japan FID executive like Enrico Corsalini or Erik Addington, when the head office starts pushing through “Repo 105” transactions, what does it do to your local balance sheet?
On the left, let’s say that is Lehman Japan. Assets and liabilities. Remember those Repo 105 playing pieces at the start of my post? Well, they are going to be accounted for using normal GAAP rules (that is, no cheating). The violet represents the cash money Lehman Japan receives as part of the Repo 105, and the red piece shows that it’s really a loan, not a sale of the bond used as collateral for the repo. Let’s value those repo playing pieces at 6.

So if the original asset block was 100, and the liabilities 97, and the green sliver a 3, (97 + 3 = 100), what happens when you have to add another 6 to both sides? You get 6 in cash on the asset side, and 6 as an increase in loans due, on the liability side.

You are going to send that cash to Lehman Brothers in Europe. Remember, the Examiner, Anton Valukas, found that the slight-of-hand occurred in Europe. So the 6 still shows on your books as a “due from affiliate”. Books are still GAAP.

Your net capital, the green sliver, is still worth 3. But it’s 3 out of a total 106. You used to have 3% net capital, now your branch office only has 2.83% net capital, (3/106 = 2.83% rounded).

If the regulator in the country you’re operating in starts to hound you about this, you probably get heartburn. Remember, Japan has Japan’s rules about this issue. You can’t just say something like, “as a foreigner, I should be ‘free to choose!!!’ which net capital rules I want to follow.” Like I mentioned the other day, this is probably why Corsalini was having the e-mail discussion with Erin Callan’s predecessor, Chris O’Meara, about possible mergers. A merger partner could bring in more capital.

The balance sheet on the right purports to be one where the Repo 105 swindle is actually carried out. Valukas determined this was Lehman Brothers International – Europe (LBIE or “Libby”). I am going to treat this balance sheet as if it is a consolidation of LBIE all the way up to actual Lehman Brothers International in New York. (Because there will be these intercompany transfers that cancel each other out.) So Libby is everything in Lehman after that.

On Libby’s books, the cash in from Japan is immediately put to use paying down Lehman’s general debt. I show this by moving the violet cash box over to the liability side, and “bolding” the border of the asset side. Now, the balance sheet that had been size 100 (how ever many billions this is) and the cash payment of liabilities just makes it size 94. The capital ratio is 3/94 or 3.19%. Lehman looks like it has proportionately more capital than it really does by hiding the fact that the red piece was supposed to be included in the puzzle.

On the consolidated books, the red piece is not recorded–that’s the fraud. Linklater’s letter said that for English law, this was allegedly “OK”. So I literally show it “off balance sheet” with a lot of question marks around it.

The cash was used to make the liability side smaller (a 91, since I didn’t mention the number). But where that 6 worth of reduction was coming from was the secret. There was this leftover playing piece that was a real loan.

A Clever Ruse

What makes “Repo 105” clever is that the participants hid it partially in the firm’s yen-carry trade, a trade that was legitimate. So to the outsider only looking at the trade blotter, an increase in repo toward a quarter end could seem as a push to get more profit from yen-carry.

As I mentioned the other day, these guys didn’t even understand the yen carry until I explained it to them. So I am confident they are not part of the Repo 105 shenanigans, although I think anyone who had a higher “view” on the process should have wondered “why the 105?” But I am debating whether the staffing at Lehman wasn’t up to snuff because of the Tokyo Talent Dearth or on purpose by Lehman headquarters . . . (or both?)